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Changing Course on a Euro-Zone Crisis Trade

For most of the last two years, the big euro-zone sovereign crisis trade has been to buy the debt of stronger northern European countries and sell that of their struggling southern peers.

But has that trade now run its course? Some investors are now backing the opposite bet: favoring Italy over France.

Italian 10-year bonds currently yield 4.9%—2.7 percentage points more than France. That partly reflects Italy's far-higher level of public debt: 126.1% of GDP in the second quarter of 2012, compared to 91% in France. Italy also faces political uncertainty tied to its elections in 2013.

But judged on other metrics, Italy fares well in comparison to France: it has a lower budget deficit, a stronger current-account position, and unemployment hasn't ballooned as in other southern European states. Italian bond issuance will fall sharply in 2013, while it remains high in France. Crucially, Italy has a long track record of managing high debt.

Italy's challenge is growth. But Prime Minister
Mario Monti
has made progress on a range of structural overhauls, including labor-market reforms, that should boost long-term growth. Italy's recession has been driven by a sharp tightening in lending standards that is now easing,
Deutsche Bank
notes.

In contrast, French President
François Hollande
has only just started on structural measures. His government announced Tuesday a package aimed at lowering labor costs via tax credits. But this didn't go as far as businesses had hoped. Meanwhile, French consumers face rising taxes and unemployment.

France's triple-A rating has so far protected it from closer scrutiny: risk-averse investors have bought French debt as a higher-yielding alternative to German bonds. But the French yield premium over Germany seem unlikely to tighten further, and France's triple-A looks at more risk than Italy's triple-B.

Of course, if euro break-up fears re-emerge in earnest, Italy will be hit harder than France. But if the crisis continues to ease, it's a fair bet Rome's bond yields will move a lot closer to those in Paris.